Educational Articles

Stock Screen: High Returns Earned on Total Capital - October 4, 2013

Kevin Downing
| October 03, 2013

One quick way to cut through the large number of available investments is to review return on total capital. This statistic measures the percentage a company earns on its shareholders’ equity and long-term debt obligations. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits plus half of the current year’s long-term interest due by the sum of shareholder equity and long-term debt. The general idea is to see how much a company earns on the money it has been given by outside investors. Companies with high scores are, presumably, better wards of capital.

That said, this measure is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries.

Since a quick review of this one measure can highlight companies that are making the best use of investor capital (on a combined basis from stock investors and bond investors), each weekly Index of The Value Line Investment Survey includes a screen listing the 50 companies that score high on this measure (subscribers can view recent and historical Index information here). A recent review of the screen turned up several companies worth a closer look, we chose to highlight one here, Lorillard (LO).

Lorillard

Lorillard, Inc. is the third-largest manufacturer of cigarettes in the United States. It boasts the top-selling menthol and second-largest selling cigarette brand overall in the U.S. (Newport Cigarettes, 87% of 2012 sales) based on gross units sold in 2012. It also has the number one U.S. electronic cigarette brand, blu eCigs. It produces five conventional cigarette brands: Newport, Kent, True, Maverick, and Old Gold. Under these labels, it has created 39 different types of cigarettes ranging in price, flavor, taste, and length. Lorillard sells to distributors, which then service chain stores and other retail channels. It has an approximate 40% share of the menthol cigarette sales in the United States.

For the last five years, the company has averaged a 7.3% compounded annual growth rate in net sales, 7.5% in operating income, and 13.3% in earnings per share. This year through the six-month mark, net sales grew 6.4%, operating income was up 9%, and earnings per share growth was 12.2%. These results were achieved while industry volumes have fallen 3%-4% each year for the past several years.

One reason for the consistently solid results is Lorillard does not believe in heavy discounting. In fact, 96% of Newport volume is sold at full price, which compares to just half the volume of the nearest menthol competitor.

We also credit the company’s ability to branch out geographically and enter new product categories for its solid fundamentals. Historically, operations have been focused in states located East of the Mississippi River, but three years ago, the company made an effort to move out West and is gaining traction there. Recently, Lorillard announced the purchase of SKYCIG, a British-based electronic cigarette (e-cigarette) business for approximately £30 million in cash. This will expand LO’s reach and diversification.

Lorillard’s domestic eCig brand is set to reach $1 billion in retail sales this year. In the first six months of 2013, it’s gone from a 10% market share to about a 44% market share, thanks partly to successful advertising campaigns featuring celebrities like Stephen Dorff and Jenny McCarthy. While LO makes no money on the eCig equipment, it still delivers margins close to those of conventional cigarettes, thanks to lucrative cartridge refills.

Another product category the company is looking to break into is non-menthol, non-full flavor cigarettes, i.e., Gold. This market is about twice the size of its bread-and-butter, full flavor menthols. Initial retail orders for Newport Gold have been solid. Product started shipping this week and management recently revealed that the low-tar cigarettes are having no problem securing shelf space.

Still, there are some regulatory concerns for the stock. Currently, the FDA is in the process of determining whether menthol cigarettes are more addictive and physically harmful to the user than the regular variety. It appears that the government needs more information to make a conclusion. If findings show that menthol cigarettes are more harmful, the company will most definitely fight the decision. We think the process will continue for another several years, and will likely cause investors to discount the share price.

Since going public, Lorillard has given over $8 billion in cash back to shareholders via its dividend policy and share repurchase program. It usually pays between 60% and 75% of free cash flow in dividends. At present, the stock’s yield is an appealing 4.84%.

Despite operating in an industry that’s experiencing secular decline, Lorillard has managed to consistently grow its business through solid execution. We think the company can continue to record impressive return on capital for many years to come.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.